The illiquidity risk premium is an excess return paid to investors for tying up capital. The premium compensates the investor for forfeiting the options to contain mark-to-market losses and to adapt positions to a changing environment. A brief paper by Willis Towers Watson presents an approach to measure the illiquidity risk premium across assets. The premium appears to be time-variant and highest during and pursuant to financial crises.

Willis Towers Watson, Asset Research Team (2016), “Understanding and measuring the illiquidity risk premium”

The post ties in with investment strategies based on implicit subsidies. See summary page here.

The below are excerpts from the paper. Headings and cursive text have been added.

What is the illiquidity risk premium?

“For us, liquidity involves… the ability to trade in sufficient volume…without negatively impacting price…with some level of confidence. The absence of any of these factors renders an asset – to some degree – illiquid. The additional return an illiquid asset offers the investor over a liquid alternative we refer to as the illiquidity risk premium (IRP).”

“The IRP compensates the investor for tying up its capital. When an investor accepts illiquidity, it accepts an increase in the uncertainty of end outcome because it is less able to liquidate the asset should something not turn out as expected. Even if the asset can be liquidated, its illiquidity manifests in lower certainty over the price available.”

“Related to this is that the investor also accepts a reduction in flexibility since it cannot replace the asset with a ‘better’ alternative (or it is potentially more costly to do so) should that become attractive. As a consequence, illiquid assets should provide a greater level of return to compensate investors for these negative aspects.”

“The level of IRP an investor should demand for a given asset – or required/fair-value IRP – has three dimensions…The investor’s utility function…the level of illiquidity…[and] the volatility and uncertainty of the underlying cash flows.”

Estimating the illiquidity risk premium

“How are we to identify the IRP of a given asset at a given time?… Broadly speaking, we follow the straightforward process set out below:

  • Establish some form of prospective yield or return. Critically this must capture, as much as possible, known uplifts to cash flows, such as those related to inflation linkage…
  • Subtract an appropriate risk-free rate. This will strip out the market’s estimated cash rate over the term of the asset…
  • Adjust for other risk premia. The focus here is on adjusting for credit risk.”

“For an actively managed strategy (often required in illiquid asset classes), additional returns may be expected from net alpha. In practice, ‘alpha’ may be hard to isolate.”

“By following this process, we are able to estimate, over time, the IRP on offer from a variety of different assets of varying liquidity.”

ILL_RP01

“The charts below show the decomposition over time of US investment-grade corporate bond spreads over US (including non-investment-grade) bonds at the most recent date. Having a decomposition by ratings band is an important innovation that enables us to size the credit risk premia of other assets if we are able to estimate the credit quality of that asset.”

ILL_RP02

“We have combined all [assets’] measures in our own Illiquidity Risk Premium Index, which is shown [below]…This takes a simple average of all the assets we have data for at a particular point in time, and plots this against the approximate fair value.”

ILL_RP03

“The messages emerging from this aggregation of IRPs in the assets we cover are:

  • Historically, there have been better and worse times to take illiquidity risk…
  • There are longer periods when our measure is below fair value (illiquidity is poorly rewarded)..:
  • In the years immediately prior to the global financial crisis, illiquidity was poorly rewarded.”